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Sarbanes Oxley and Fiduciary
Best Practices for Officers and Directors of Nonprofit Organizations
In the aftermath of the Enron bankruptcy and the domino effect of accounting scandals and suits against management it perpetuated, new standards of corporate governance and management accountability are emerging. In 2002, Congress enacted the Sarbanes-Oxley Act (the "Act" or "SOX") to address some of the weaknesses in the governance of public companies. Nonprofit fiduciary duties parallel the obligations imposed on officers and directors of public corporations, and while the Act does not extend to not-for-profit organizations ("NPOs"), it may set the standards by which corporate governance is judged for all entities with a public responsibility. This article discusses whether NPOs should apply Sarbanes-Oxley standards in their corporate governance and will consider why such regulatory measures are necessary. WHY NONPROFITS SHOULD KNOW ABOUT SARBANES-OXLEY SOX was enacted to define certain duties of those serving as officers and directors of public corporations. Those serving non-profits in a fiduciary capacity should consider Sarbanes-Oxley governance standards because the Act sends a message that corporate fiduciary duties, including those at common law, should be strictly enforced.1 Thus, after Sarbanes-Oxley, board members and management must be cognizant of their duties not only for the health of the organization, but also to avoid personal liability. While the Act itself is only applicable to public corporations, all individuals serving in a fiduciary capacity to a corporate entity are subject to certain common law duties. The first of these is the Duty of Care.2 Fiduciaries are entrusted with a great deal of power and discretion and the Duty of Care requires that they make decisions for the organization on a reasonably informed basis. This means that, while officers may delegate responsibility, they must ask questions and maintain reasonable control and supervision over management. The second duty is the Duty of Loyalty.3 This seeks to prevent self-dealing and misappropriation of funds by requiring officers to avoid conflicts of interest between themselves and the corporation. The Duties of Care and Loyalty are basic principles of Anglo-American fiduciary law. Applied to the nonprofit sector they provide the backbone for much of the state and federal regulation of NPOs and can be relied upon even in the absence of an express statutory duty. Recently, some have questioned the judiciary's commitment to these principles, as there are relatively few modern cases in which they have been applied to either the for-profit or the non-profit sector.4 However, Sarbanes-Oxley expresses clear congressional intent that the policy goals behind these Duties be upheld. SARBANES-OXLEY: CURRENT TRENDS IN REGULATION Congress enacted the Sarbanes-Oxley Act in 2002 in the wake several multi-level corporate accounting scandals.5 The Act has three major provisions: first, it establishes a government agency under the SEC to oversee accounting practices of public corporations. Second, the Act expands the current level of accountability for executives and mandates a heightened level of involvement by Boards of Directors to oversee the company's accounting and finance practices. Third, the Act requires independence of auditing firms and prohibits accounting firms from performing consulting and other non-accounting functions. The Act has also overruled certain practices common in the corporate arena and legal under many state laws that have facilitated self-dealing and impeded transparency. More important than the provisions of the Act, however, are the underlying policy goals. Although nonprofits do not have as explicit a federal regulatory schema as for-profit corporations, the underlying policy goals are the same: transparency, fair dealing, and the basic principles of fiduciary law.6 The following discussion considers some of those policy goals, first in the context of the Sarbanes-Oxley Act, and then under common law fiduciary duties. The article also suggests tools that nonprofits can use to comply with the policy goals of the Sarbanes-Oxley Act. Officer Responsibility and the Duty of Care The Sarbanes-Oxley Act requires the principal executive officers and chief financial officers of corporations to certify to the truth of quarterly and annual reports.7 Officers must also establish and maintain internal controls to make sure that important information is being circulated to those in charge of making decisions for the corporation. The Act mandates stiff penalties for noncompliance: if the report is not in line with federal reporting guidelines, the executive officers who certified the report forfeit any bonuses or equity-based compensation received during the 12 months following the date the statement was issued and could potentially face a fine up to five million dollars and be sentenced to up to 20 years in jail.8 The goal of the Sarbanes-Oxley Act Chief Executive Officer certification provision is to require executives and directors take an active role in remaining informed about the finances of the corporation. Along the same lines, here are two simple measures to ensure individuals on NPO Boards of Directors understand both their duties to the organization and how the NPO functions. Fiduciary Duties and the Informed Officer Even though their legal obligations are similar, NPO Boards of Directors
serve different functions than those in the for-profit sector. Board members
are often chosen more for their fundraising potential than for their expertise
in the field. Also, whereas Board members in for-profit corporations are
subject to the threat of derivative suits from shareholders or oversight
agencies, those on non-profit Boards enjoy an atmosphere in which there
is limited standing to sue and are protected by the Good Samaritan statutes
currently on the books in many states.9 Taken
together, these factors create a disincentive for members to take an active
role in the management of the enterprise. The Revised Model Nonprofit Corporation Act,11 which has been adopted by several states, provides good resource for Boards when seeking direction for their own corporate director policy. A nonprofit should also consider creating a compliance committee to draft and dispatch the policy statements and to keep Board members regularly informed of new developments in the organization's governance.12 The Nonprofit's Annual Report: Towards a More Educated Board An important way for NPOs to keep Board members informed is through distribution of periodic fiscal reports. Similar to the annual reports filed by public corporations, the Tax Code already requires most NPOs to file Form 990, an annual financial information return that discloses the NPO's income and expenditures for the year.13 The Form disclose how much the NPO pays its executives, how much it has distributed for its nonprofit purposes, how much it has spent on political lobbying, and money spent in any transactions with other organizations.14 Form 990 provides a valuable template to organizations seeking to establish their own regulatory systems. As an educational tool, a summarized compilation of the organization's accounting data can be easily circulated among the NPO's Board to familiarize members with the workings of the organization. Collecting and disseminating such data also has collateral benefits. The information can be distributed to potential donors or to the media as a public relations tool to show that the organization's spending mandates are in line with the organization's charitable philosophy. The Auditing Committee Function: Advancing an Active Board of Directors The Sarbanes-Oxley Act requires that each company maintain an Audit Committee on their Board of Directors. The members of the audit committee must be independent and are prohibited from accepting consulting fees or maintaining any affiliation with the company outside of their role on the Board of Directors.15 The Committee is to handle the hiring and oversight of the company's outside accounting firm and will also have primary responsibility for establishing procedures for filing complaints having to do with any accounting or auditing matters. Likewise, Sarbanes-Oxley also requires the independence of auditing firms and prohibits them from providing non-audit services to their clients.16 If the accounting firm employed any of the company's executive officers during the one-year period preceding the audit, the accounting firm is not independent and cannot perform the audit. Before the Sarbanes-Oxley Act, no state or federal law defined the role of a company's Auditing Committee or even required that a company have one. Applied to the nonprofit sector, an Auditing Oversight Committee is one of the most efficient means available for an NPO to ensure executives are accountable and informed about the financial health and the direction of the organization.17 Similar to the Sarbanes-Oxley Act provision, the Audit Committee for an NPO should have primary responsibility for overseeing fiscal matters of the organization. Individuals serving on the accounting committee should be independent, not having any other ties with the NPO. At least one member should have some knowledge of corporate accounting and all should receive some training in line with Generally Accepted Accounting Principles.18 The auditing committee should likewise be in charge of promulgating rules and procedures for preparation and dissemination of financial statements. With regards to the auditing firm, Sarbanes-Oxley sets up a fairly strict structure for regulating relationships between corporations and their auditors, something that many NPOs may not be able to afford. Nevertheless, NPOs should make sure that the audit firms are as independent as possible and, where economically feasible, also consider rotating firms periodically.19 The NPO should communicate with the auditor via the Auditing Committee to make sure that there is no undue influence from management. Providing sufficient fiscal safeguards and procedures for communication between the organization and the auditing firm can help prevent the mismanagement of organization funds and promote the overall financial health of the NPO. The Duty of Loyalty: Preventing Self-Inurement The Sarbanes-Oxley Act also contains several provisions to prevent conflicts of interest and potential employee self-dealing. One provision prohibits corporations from extending loans to executives, which are usually excessive and rarely repaid.20 A second requires the disclosure of all off-balance sheet transactions to the SEC, a practice some corporations have used to hide losses or divert funds.21 The policy goal of the above Sarbanes-Oxley provisions is the prevention of self-dealing. The Internal Revenue Code and many state nonprofit regulatory systems contain similar prohibitions against self-inurement, or the restriction against personal gain arising out of affiliation with an organization.22 The prohibition against self-inurement can be understood as one extension of the common law Duty of Loyalty, which requires that individuals serving in a fiduciary capacity act solely in the interest of the enterprise and refrain from engaging in activities in which they might obtain personal benefits or have an individual interest. However, while the prohibition against self-inurement is usually attached to the organization's tax-exempt status, the Duty of Loyalty establishes personal liability for the individual fiduciary engaged in self-dealing.23 Often, members serving on a nonprofit Board of Directors are volunteers and do not see any monetary gain whatsoever. However, inurement issues can arise in situations where there is a conflict of interest between the organization and a board member, for example where a member buys or sells a piece of property or conducts other transactions with the corporation.24 Many smaller charities depend heavily on interested transactions, relying on a director's contacts, if not the director herself, to obtain goods or services more cheaply than would otherwise be possible. Unchecked, such transactions may provide an opportunity for the board member or officer to siphon money away from an organization.25 Fortunately such transactions are not per se violations of fiduciary principles so long as all parties acted in good faith and the transaction was fair and open.26 However, it is important that such dealings between an officer and the organization be reviewed with heightened scrutiny by noninterested Board members to avoid misappropriations of organization funds. Keeping in step with the policy goals of SOX against self-dealing, NPOs should have a policy in place to inform members about various legal duties when making contracts or engaging in transactions with the organization. For a template of such policies, NPOs can look to the American Law Institute, Principles of Corporate Governance 27 and the Corporate Directors Guidebook,28 which also lay out other practices that can be easily adopted by nonprofits to make sure that all transactions, interested and otherwise, are open and reviewable. CONCLUSION The tools listed above as promoted by the passage and application of SOX are a good start to establishing a functional NPO Board policy regarding fiscal and fiduciary matters. NPOs must also be cognizant of local as well as federal regulations regarding fiduciary duties and disclosures, as supervision of nonprofits is for the most part left up to the states. Where feasible, NPOs should obtain the advice of legal counsel and the services of an accountant to make sure that they are in compliance.
Footnotes * The author acknowledges with appreciation Tom Frechette and Melanie Taylor for their valuable assistance in researching and preparing this article for publication 1Brian Kim, "Sarbanes-Oxley Act," 40 Harv. J. on Legis. 235 (Winter 2003); Lisa Fairfax, "The Sarbanes-Oxley Act: Confirmation of Recent Trends in Director and Officer Fiduciary Obligations," 76 St. John's L. Rev. 953, 960 (Fall 2002) (interpreting Sarbanes-Oxley as "buttress[ing]" the fiduciary duties of board members and management). 2For an overview of nonprofit fiduciary duties, see Harvey J. Goldschmid, "The Fiduciary Duties of Nonprofit Directors and Officers: Paradoxes, Problems, and Proposed Reforms," 23 J. Corp. L. 631 (Summer 1998); James J. Fishman, "Improving Charitable Accountability," 62 Md. L. Rev. 218 (2003); Jaclyn A. Cherry, "Update: The Current State of Nonprofit Director Liability," 37 Duq. L. Rev. 557 (Summer 1999); A. Gilchrist Sparks, III and Lawrence A Hamermesh, "Common Law Duties of Non-Director Corporate Officers," 48 Bus. Law. 215 (Nov. 1992). 3Fishman above note 2, at 234; Goldschmid above note 2, at 646. 4See Fairfax above note 1, at 959 (although individuals serving in a fiduciary capacity are held to a reasonable person standard, courts are rarely willing to find a breach in the Duty of Care absent a showing of "gross negligence"). But see Goldschmid above note 2, at 642 (arguing that the belief that standards are "quite low" is a myth, as state courts, where nonprofit cases are normally adjudicated, are still quire willing to apply the Duties of Care and Loyalty). 5The Sarbanes-Oxley Act of 2002, P.L. No. 107-204, 116 Stat. 745 (2002). 6P.L. No. 107-204, §302(a), 116 Stat. at 777. See Kim above note 1; Charles M. Nathan, "The Sarbanes-Oxley Act: A Spotlight on Individual Officers, Directors, and Legal Counsel," NCMA Glass-CLE 319 (Aug. 2002). 7P.L. No. 107-204, §302(a), 116 Stat. at 777. 8P.L. No. 107-204, §304(a), 116 Stat. at 777. 9See Karyn R. Vanderwarren, "Financial Accountability in Charitable Organizations: Mandating an Audit Committee," 77 Chi.-Kent L. Rev. 963, 965 (2002); Goldschmid above note 2, at 636-638. Because the goal of the organization is not to maximize profits, as is the case with public corporations, members of NPO Boards of Directors tend to have more diverse backgrounds and reasons for joining the organization. 10See Goldschmid above note 2, at 645. Understanding the role of the Business Judgment Rule ("BJR") as the other side of the coin called the Duty of Care can provide a buffer against liability for directors and managers of nonprofit organizations. Although there are few cases in which the BJR has been applied to nonprofit directors, the doctrine is consistent with other basic fiduciary principles to which nonprofit directors are subject. See also Denise Ping Lee, "The Business Judgment Rule: Should It Protect Nonprofit Directors?" 103 Colum. L. Rev. 925 (May 2003). 11The Revised Model Nonprofit Corporation Act (1987), available at http://www.paperglyphs.com/nporegulation/documents/model_npo_corp_act.html. See also Peggy Sasso, "Searching for Trust in the Not-For-Profit Boardroom: Looking Beyond the Duty of Obedience to Ensure Accountability," 50 UCLA L. Rev. 1485, 1522 (August 2003) (defining the Duties of Loyalty and Obedience under the RMNCA). Many states adopted either the original Model Nonprofit Corporation Act (1964) written by the American Bar Association, or the later Revised Model Nonprofit Corporation Act. Other states have their own laws, which may vary substantially from either of these two templates. 12See Vanderwarren above note 9, at 968; Fishman above note 2, at 239. 13Vanderwarren above note 9, at 969 Vanderwarren points out that, while the IRS requires many organizations to file an annual Form 990, officials rarely scrutinize the forms, which are often incomplete. Here, we offer a different use for the form. To educate Board members, Form 990 may be utilized as a bare-bones template for collecting and organizing the organization's fiscal data. Even if not disclosed to the public, the information, laid out in a coherent fashion, can provide the Board Members with a good overview of the organization's fiscal standing. See also Susan N. Gary, "Regulating Management of Charities: Trust Law, Corporate Law, and Tax Law," 21 U. Haw. L. Rev. 593, 519 (Winter 1999) (briefly discussing a regulatory trend toward disclosure to the public). 14See also Lisa M. Fairfax, "The Sarbanes-Oxley Act as Confirmation of Recent Trends in Director and Officer Fiduciary Obligations," 76 St. John's L. Rev. 953 (Fall 2002) (defining executive and director Duties of Care and Inquiry under Sarbanes-Oxley). 15P.L. No. 107-204, §301, 116 Stat. at 775. 16P.L. No. 107-204, §201, 116 Stat. at 771. 17See Vanderwarren above note 9; James J. Fishman, "The Developments of Nonprofit Corporation Law and an Agenda for Reform," 34 Emory L. J. 617 (Summer/Fall 1985). Recommending an NPO Audit Committee and its practical function. These articles also lay out potential alternatives to some of the recommendations advanced here. 18See also Gary above note 13, at 642. 19Vanderwarren above note 9, at 891. 20P.L. No. 107-204, §402(a), 116 Stat. at 787. 21P.L. No. 107-204, §401(a), 116 Stat. at 785. 22Evelyn Brody, "A Taxing Time for the Bishop Estate: What is the IRS's Role in Charity Governance?"21 U. Haw. L. Rev. 537, 544 (Winter 1999) (Notes that revocation of tax exempt status is not the IRS's only weapon; they may also sue individual officers and require that they repay excess benefits to charity). 23See also Darryll K. Jones, "The Scintilla of Individual Profit: In Search of Private Inurement and Excess Benefit," 19 Va. Tax Rev. 575 (Spring 2000). 24See, e.g., 26 U.S.C. §4958. 25During the mid-90s, United Way suffered a serious scandal when its President William Aramony was found to have used his position to embezzle hundreds of thousands of the organization's money. 26Fishman above note 2. 27American Law Institute, Principles of Corporate Governance: Analysis and Recommendations §5.02 (1994). 28"The Corporate Director's
Guidebook," 56 Bus. Law. 1571 (Aug. 2001). |
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